The term “tax harvesting” refers to using current investment holdings in a loss position to decrease the amount of income tax that you may have to pay. Tax harvesting can help reduce your income tax bill. Harvesting can be a good idea if you have been holding something in the hope it will regain its unrealized losses you have been holding on to.
Investment losses can be used to offset investment gains and income (up to $3,000), which can make tax harvesting very beneficial when done correctly. By minimizing capital gains tax, you can save money at tax time, which, in turn, allows your investments to grow exponentially.
What is Tax Harvesting?
Tax harvesting is a money-saving strategy that allows you to decrease the amount of tax that you must pay on capital gains. The method involves selling investments that you know will be at a loss. You then take this loss and use it to offset your capital gains. If losses exceed your gains, they can also be used to offset up to $3,000 in non-investment income as well.
Tax harvesting can only be used if you have investment income, but that does not include most retirement accounts like IRAs and 401(k)s because they are tax-deferred accounts.
An Example of Tax Harvesting
Imagine that you invest $10,000 in the S&P 500. After it sits for two months, you end up losing 10% so that the value of your investment is now $9,000. You decide to sell it and take the $1,000 loss so you can invest your $9,000 in other investments.
Because you have reinvested the money, your market exposure does not really change, but you have experienced a short-term loss for tax purposes. That $1,000 short-term loss can be used to offset any combined short or long-term capital gains that you realize—decreasing your overall income tax obligation.
The Why: The Benefits of Tax Harvesting
Tax harvesting gives you immediate tax savings. However, the real goal of this process is actually to delay having to pay taxes. By using losses to offset gains, you essentially allow an investment to grow and compound at a faster rate than if you had to pay taxes on the profits each and every year on the unrealized gains.
When used correctly, tax harvesting allows you to essentially create a tax-sheltered retirement account through a taxable investment account. A tax professional can help you with this process and get as much out of tax harvesting as possible for your unique tax situation.
Limitations to Tax Harvesting
There are some very specific (and sometimes complicated) limitations to tax harvesting that you should consider. Knowing these at the outset will help you take full advantage of these tax savings.
Losses Offset the Same Type of Gain
You have to offset the same type of gain first. That means that short-term losses offset short-term gains, and long-term losses offset long-term losses. Then, net losses can be deducted from the other gains.
Overall, through tax harvesting, you can offset 100% of gains should you have enough of unrealized losses were you to harvest those unrealized losses. However, the value of the deduction varies based on the type of gain because they are taxed at different rates. Short term gains are taxed at higher rates—up to 37% for the 2019 tax year. Long-term gains, on the other hand, will top out at a rate of 20%.
Once you have offset all of the capital gains, then you can offset regular income up to $3,000. If you do not use all of your losses, then some may carry over to the next year. There are limitations to loss carryovers, as well.
The Wash Rule
The IRS does not want you to purchase investments and sell them just for the purpose of realizing a loss and saving on taxes. For this reason, they have created the “wash” rule.
The wash rule does not let you use losses if your purchase substantially the same investment either 30 days before or 30 days after the transaction they triggered the loss. You can wait 31 days to avoid this rule, or you can use your money in another type of investment.
Using Tax Harvesting Effectively in Connecticut
Tax harvesting is hugely beneficial, but it can be complicated, and every state, including Connecticut, has its own individual nuances. Learn more about this tax-saving avenue by contacting our team. We can walk you through how it works and how it will play out for your unique situation.
Contact one of our offices if you have questions about how tax harvesting might apply to your circumstances. We are happy to review your previous year’s taxes and discuss your current situation to make suggestions on how you can use the rest of this year to your advantage. If you’d like to have a consultation, please give us a call at our Meriden office 203-634-7549 or Madison Office 203-318-1488 or fill out our contact form and someone will get in touch with you.